Gold Futures
CoT 2

I have loved reading my entire
life, so when I am not studying the financial markets one of
my favorite pastimes is reading great fiction. My favorite genre
these days is the rich adventure/action stories spun out by brilliant
authors like Clive Cussler, Jack Du Brul, and James Rollins.
A good book makes even the very best movies seem like shallow
grade-school plays by comparison.

Adventure stories often have
history woven in as the heroes chase after some priceless artifact.
Usually some ancient priest-type caste existed that hid the artifact
away to protect it from a calamity in the past so our heroes
can unlock its secrets in the present. These historical priests
often used special knowledge that only they had, usually scientific
in nature, to cement their power in the society.

As an example, some high priest
might know through a lifetime of studying the heavens that a
solar eclipse was due soon. So he would use this knowledge to
gain temporal power. He would tell the king that the gods were
displeased with him and were going to blacken the sun on an appointed
date. Then after the event happened as prophesied and the king
came groveling in fear, the priest could demand anything to bring
back the sun.

Similar mysticism continues
to cloak the futures markets today. Futures traders are very
small in number compared to stock traders, so to stock traders
the futures world seems esoteric and impossible to comprehend.
Thus gurus have arisen to act as interpreters to stock traders
to explain happenings in the futures world. Like the adventure-story
priesthoods, disturbingly often the futures gurus tell half-truths
and withhold information so they can retain or enhance their
popular status as gurus.

In some circles the futures
priesthood holds very little sway. The vast majority of mainstream
investors, for example, probably aren't even aware of theories
that exist alleging S&P 500 futures manipulation to help
steer the stock markets briefly at key inflection points. They
don't care what happens in stock futures and aren't worried about
them adversely affecting their stock portfolios.

But in other areas of the markets,
typically small underdog contrarian-dominated ones, the futures
priesthood wields great influence. Stock investors worry constantly
about what is happening in the futures and they look to gurus
to interpret the esoteric signs in futures trading that may affect
them. The key example of this I have observed for many years
now exists in gold. Gold-stock traders tend to have great interest
in, and trepidation for, what is happening in gold futures.

Sometimes this interest blossoms
into full-blown paranoia. If I had an ounce of gold for every
time I have read something like the following since this gold
bull began six years ago, I could start my own central bank.

Remember reading endless comments
like these? "Commercials are record short, they are capping
gold." "Gold open interest is plummeting, Wall Street
is trying to scare traders out of the market." "The
large specs are setting the small specs up in a trap, the little
guys are going to get slaughtered." "Paper gold is
more important for the gold price than physical supply and demand."
"Gold OI fell by 25,000 contracts today, a record. The smart
money is abandoning ship."

In general, the overall theme
the futures priesthood tries to impart to its stock-trading followers
is negative. It says that little traders are always at the mercy
of the big traders, so when little traders lose money in gold
stocks it is not their fault. It wasn't because they made the
wrong decisions on timing or stocks, but because powerful forces
beyond their comprehension in the futures world were toying with
them. People love avoiding accountability for their own actions.

Naturally with this victim-mentality
focus, the futures priesthood's influence is greatest when gold
stocks are the weakest and stock traders seek explanations for
their falling portfolios. It is far more comfortable to attribute
one's losses to "them" rather than simply one's own
incorrect buy/sell timing. Unfortunately a sizeable subset of
our Zeal subscribers get caught up in this futures mysticism
when their holdings are not performing well, so I am writing
this essay for them.

Although futures trading is
more complex than stock trading, it is very straightforward and
does not need to be cloaked in mysticism. Anyone can easily understand
the broad trends in gold futures trading, and just like in every
other market most of the day-to-day fluctuations in futures are
just meaningless random noise. With a little bit of understanding,
gold futures rapidly shed their sinister reputation in stock
traders' minds.

The first thing that is crucial
to understand is, unlike stocks, futures are a zero-sum game.
This means that every dollar won in a gold futures trade is a
direct dollar loss for the counterparty on the other side of
the trade. In this type of trading, every long contract is perfectly
offset by an opposing short contract. Thus the total number of
longs and shorts at any given time is always equal, in perfect
equilibrium.

This basic fact that everyone
should know never ceases to amuse me. I can't count the times
that I've read futures gurus warning that "record short
positions exist in gold so it cannot go any higher". Well,
obviously if record short positions exist then record long positions
have to exist too! Perhaps the glass should be seen as half full
rather than half empty. In a pure zero-sum game, there are always
equal numbers of contracts betting for or against any given asset.

One of the key statistics the
futures priesthood eagerly watches is open interest. Open interest
is the futures term used to quantify the total number of futures
contracts outstanding at any given time. Since each contract
has an equal long and short side, OI only counts longs or shorts,
but not both. To count both would overstate true open interest
by 100%. Over time, OI trends reveal whether the capital involved
in a futures market is growing or contracting.

This first chart takes a look
at COMEX gold futures open interest in the US in our gold bull
to date. Although gold is traded around the world on many different
futures exchanges, so far COMEX gold prices have been the most-watched
price. I don't think this US dominance will last forever given
the US dollar's increasingly precarious
technical position, but for now it still holds true.

Virtually all of the futures
data that you will ever see analyzed, including this bull-to-date
gold open interest, comes from the Commitments of Traders Report.
Each Friday, the Commodity Futures Trading Commission releases
its CoT report. It summarizes changes in futures positions held
by the major classes of commodities traders. It is definitely
useful, but it is complex so an air of mysticism has sprung up
around it.

In terms of gold open interest
reported in these weekly CoT reports, it has risen dramatically
since gold bottomed in April 2001. Back in mid-2001, there were
only 100k total contracts of COMEX gold outstanding. But in recent
months gold OI broke 400k contracts for the first time in this
bull market. Overall from trough to peak, COMEX gold futures
OI has blasted 321% higher.

The higher gold goes, the more
traders are interested in participating in its bull market. Investment
assets are pretty unique in this regard in that higher prices
drive higher demand, which is the opposite of most typical commodities.
If corn prices triple, corn demand will drop as corn users seek
lower-priced substitutes. But if gold prices triple, investors
and speculators want even more as they seek to chase its momentum.

Gold prices have indeed nearly
tripled since their April 2001 lows, and gold futures OI has
quadrupled. It is wonderful to see gold futures OI rise with
gold because it shows ever-wider interest in the gold bull from
bigger pools of capital. Obviously the more capital that ultimately
bids on gold, the higher this bull market will ultimately climb.
The more investors and speculators that follow us in, the greater
our profits will ultimately be.

I find it particularly fascinating
that gold OI has risen in a very well-defined uptrend so far.
Yes, gold OI will rise and fall depending on the tactical fortunes
of the gold price, but over time these flows and ebbs have tended
to form remarkably solid support and resistance lines. Although
there is certainly no guarantee this trend will hold into the
future, these OI extremes are tradable.

If you carefully examine gold
OI versus the gold price above, you will note that it tends to
rise when gold is strong and fall when gold is weak. This makes
sense since traders are much more likely to be interested in
participating in a hot market than a slow one. So if OI is near
support, probabilities favor gold moving higher. If it is near
resistance, probabilities favor gold consolidating sideways or
correcting lower. While gold does not always follow these OI
trading rules, they can help supplement signals offered by other
more accurate trading
tools.

And getting back to the futures
priesthood always scaring the stock traders, an important observation
is plainly evident above. While gold OI has risen on balance
in this bull, it has also fallen sharply over a dozen times so
far. Yet despite all these sharp OI plunges, gold has somehow
managed to advance 181% higher in its bull to date. And these
sharp plunges that drag OI back near support tend to mark low
points in the gold price, great times to buy.

So the next time you hear some
guru lament that gold OI is plummeting so the gold price must
be in trouble, realize it is mystical nonsense. Gold OI falls
sharply multiple times every year, yet the gold bull powers higher
on balance despite this. Taking a sharp change in OI out of context
is irrational and silly. Unless the OI change radically violates
this uptrend one way or the other, it is probably not even worth
thinking about.

Now the venerated CoT reports
that the high priests graciously interpret for us mere mortals
are indeed complicated. A couple years ago I downloaded CoT data
for futures for a single year and the spreadsheet contained 129
columns and nearly 3500 rows of data. I have worked with spreadsheets
of CoT data that weighed in at a whopping 40 megabytes! Raw CoT
data is voluminous, complex, and intimidating.

But like most complex things,
it can be distilled down into basics that stock traders can easily
understand. The Commitments of Traders Report is exactly what
it sounds like, it shows what three basic groups of traders currently
have open in terms of gold futures positions. While the total
number of gold longs and shorts is always perfectly equal, the
internal proportions of these positions held by the three groups
change over time and these changes are what is analyzed.

The raw CoT has two major groups
of traders and a third minor one that acts as a plug to balance
out the first two. The first category of traders is "non-commercial".
These are large traders buying and selling gold futures that
are not actually producing or consuming real physical gold. Hence
they are the speculator side of the futures trade and are more
commonly known as large speculators.

The second major group of traders
is the "commercial" category. Commercials are large
traders too, but they are theoretically actually producing or
consuming real physical gold. Thus they are the hedger side of
the futures trade. They are trying to lock in their gold price
on the buy or sell side so they can better plan their business
operations. Commercials, of course, are the notorious group that
the futures priesthood drums up the most fear about.

The third group is quite small
compared to the first two, and indeed it represents the mathematical
difference between the large speculators' and hedgers' positions.
These are the "nonreportable positions", or futures
traders that are so small they don't have to report their trades
to the Commodity Futures Trading Commission. These are more commonly
known as small speculators.

Each group has longs and shorts
outstanding, but if all of their longs and shorts are added together
it yields a net-long or net-short figure. Over time these net
positions can be charted and analyzed. And of course since futures
are a zero-sum game, net longs and net shorts are always equal.
If longs are thought of as positive and shorts as negative, the
total positions always add up to zero.

Here are the three groups'
net positions in gold futures charted over the entire duration
of this gold bull. The futures priesthood loves to take one aspect
of this perpetually balanced market, usually the commercials'
net shorts, and blow it way out of proportion. But if you can
maintain perspective, there is certainly nothing ominous in this
data as we stock traders are often led to believe.

Now the strategic story of
this chart is pretty simple. Over the course of this gold bull,
commercial hedgers' net-short position has grown greater on balance.
This naturally spooks gold-stock traders who fear gold futures.
Offsetting this increase in hedger net shorts though is a trending-higher
net-long position held by large speculators. And curiously small
speculators', largely individual traders, net-long position has
been essentially flatlined for years despite the powerful gold
bull.

Does this mean that hedgers
are getting more bearish on gold and speculators are getting
more bullish? Not necessarily, especially in the case of the
hedgers. While I personally hate hedging and wish no commodities
producers ever did it, it is a fact of life in the gold-mining
industry. Hedgers have good reason to continue hedging a portion
of their production, even in a secular bull.

Gold mining is an expensive
and risky business. Once a promising deposit is found, tens or
hundreds of millions of dollars must be spent drilling it to
define the ore body and develop an optimal mining plan. And once
this mining plan is ready, hundreds of millions or billions of
dollars must be spent to actually build the mine. All this cash
necessary to finance such big projects has to come from somewhere.
Gold companies have two choices to get it, either issue new shares
to raise the cash or borrow the money.

Issuing new shares irritates
gold-stock investors to no end. We do not want to be diluted,
have our ownership percentage drop, as new shares are issued.
Also, ultimately issuing new shares is the costliest way to finance
a mining project. Instead of the new financiers being paid a
fixed cost for their capital, these new shareholders have a full
unlimited profit interest in future production. Stocks usually
sell off sharply on major new share issuances because stock investors
loathe them.

The only other alternative
for raising cash is borrowing it. The debt markets are a far
cheaper way to develop a gold mine over the long term. Debt investors
get a fixed rate of return on their capital and that is it. If
the gold mine is fantastically profitable, all profits above
and beyond interest expenses go to existing shareholders. Over
the long haul, shareholders in companies that finance their projects
with debt usually fare a lot better than shareholders in companies
that continually issue new equity.

But banks lending miners money
are not hardcore secular commodities bulls like individual investors.
They want assurance that they'll get their principal back when
the mine goes live regardless of prevailing market conditions.
Thus they almost always demand some level of hedging in order
to issue the loan. Gold companies that borrow money to build
mines usually have to hedge some fraction of future production
as part of their debt covenants. Now they are obviously bullish
since they are building a gold mine, yet they still have to effectively
short some gold in order to finance the mine.

Another scenario where companies
feel a legitimate need to sell gold before they produce it exists
in operations where gold is the byproduct, not the primary metal.
A big copper producer may end up mining a lot of gold with the
copper ore it extracts and processes. But since it is not in
the gold-mining business, it really doesn't care about gold prices
and chooses to hedge its byproduct gold production.

Now once again as an investor
and speculator I am not a fan of hedging and wish it didn't exist
at all. But my point here is that it does exist and is not necessarily
nefarious and anti-gold. If a company I own wants to build a
major new gold mine that will increase my future profits radically,
but it must hedge 10% of the production out of that particular
mine to get the loan, I can live with that. Ultimately it is
good for me as a stock investor.

Back to the chart, in late
2005 when the hedgers' net-short position reached record highs,
the futures priesthood was going bananas. All of the futures
gurus that I followed were very bearish back then. Gold had consolidated
sideways for all of 2005 until that point and the record net-short
position of the commercials must have meant that a big gold decline
was imminent. "The commercials are always right", they
said. The bearish hysteria back then due to futures mysticism
was unreal.

But interpretation is very
important in the markets. This next chart zooms in so these record
net-short hedger positions can be more easily seen. At the very
moment the commercials were heavily short, the large specs were
heavily long. So was the glass half empty or half full? I was
betting on the latter back then since gold was due for a major
upleg after its long consolidation. It turns out the large specs
were right in spades.

The record net-short hedger
position in late 2005 occurred very early on in the biggest gold
upleg we've seen by far in this entire bull market. This isn't
always the case, as sometimes new record commercial net-short
levels appear near tops, but it does illustrate that record commercial
net shorts considered in isolation are nothing to fear. Hedgers
will continue to hedge for valid business reasons until the end
of time, regardless of the gold price trend.

While the futures priesthood
frets about commercial shorts, which will continue to grow with
open interest in this bull market, one thing I don't see them
address is the flatlined small speculator net-long position.
You would think that as this gold bull powers higher, more small
speculators would start playing in gold futures and their net-long
position would trend higher. So far this hasn't been the case
though. While I don't know why, I do have some theories after
watching this for years.

First, these three CFTC-reported
trader categories are a bit nebulous and I really doubt their
precision. The small specs are nonreportable, they are a mathematical
construct necessary to make large specs and hedgers balance out.
Viewed this way, as a kind of accounting plug rather than actually
measured individual futures traders, it makes sense that this
difference between hedgers and large specs would be fairly constant
over time.

Second, even within the major
hedger and large-spec categories, CoT classification is not rigorous.
For example, imagine a big Wall Street bank trades in gold futures,
some for its own account and others for its clients. The bank
will probably be classified as a large spec. But it may have
clients that are really hedgers, like a jewelry store for instance.
The jewelry store will want to lock in gold prices for commercial
reasons but its futures could be held in the bank's street name
and hence classified as a large spec rather than a hedger. Similarly
a small-spec client could be classified as a large spec if its
positions are held in the large spec's street name.

For this reason I don't have
a lot of confidence in the arbitrary CFTC line between hedgers
and speculators on its CoT report. There is no doubt that some
are classified in the wrong category. This realization is kind
of amusing too, as the CoT data that futures gurus sweat over
is likely fairly subjective. It is not rock-solid like price
data, but is fuzzy based on classification.

Another problem with CoT data
is it is just for one futures contract traded in one country.
Gold is traded worldwide on many exchanges, so the US CoT is
never an accurate reflection of global positions. And many gold
contracts between major buyers and sellers are cut privately,
off the exchanges, so they never show up in futures data anyway.
This means the CoT has a very narrow and myopic focus compared
to the global gold market's true scope. Thus it is too provincial
to accurately reflect a global market.

Finally, there are good reasons
why the vast majority of small speculators prefer betting on
this gold bull with gold stocks instead of gold futures. Of course
stocks are easier to trade than futures and are perceived as
less risky since stocks don't have expiration dates and can't
be bought on extreme margin like futures can. This is not an
accurate perception if margin is excluded though, as an unleveraged
stock trade is far riskier than a hypothetical unleveraged futures
trade.

I prefer gold stocks to gold
futures for my own personal speculations simply because the risks
and rewards in gold stocks are much greater. Yes, a company can
see mine X fail to produce at plan or country Y go all Marxist
and steal its flagship project. But when a company is successful
at mining gold, its stock-price appreciation dwarfs gold appreciation
and even far exceeds margined gains on gold futures. Bull to
date at best the gold price is up 181% but the leading gold-stock
index, the HUI, is up 996%. So gold stocks have leveraged gold's
gains by 5.5x so far in this bull market!

Stocks also have other advantages
over futures. There is usually only one major gold futures contract
traded in a given country, so all futures speculators study it
relentlessly. Since they only have one price to follow, they
all become experts on it and it is really hard to achieve information
superiority and beat the professional traders at their own game.
If their only focus is gold futures, they will get darned good
at trading them.

On the other hand, there are
many hundreds of gold stocks. With so many stocks to follow,
most traders know very little about all of them and no one is
an expert on many. This perpetual lack of information means there
are countless opportunities to exploit information asymmetry.
A promising new gold miner may be trading at deep bargain prices
simply because not enough traders know about it yet. Opportunities
like this just don't arise in the singular gold-futures world.

Another big advantage stocks
have over futures is their proportion of irrational traders.
Margined futures trading is extremely unforgiving, so if a new
trader isn't really good he is going to go broke sooner or later.
This leaves a high proportion of very competent professional
traders dominating gold futures. They eat new guys for lunch.
But in stocks, everyone trades them. While most futures traders
are good, most stock traders are bad. They are naïve and
dominated by emotions which leads to poor trading decisions and
price anomalies on both the high and low sides that we rational
traders can exploit for profits.

So while stocks are higher
risk, their potential returns are much higher too. So I believe
there is very good reason why individual speculators would prefer
to trade in the gold-stock sector rather than in gold futures.
There are just so many more opportunities in gold stocks since
they aren't followed as closely and a vastly higher proportion
of irrational traders drives countless exploitable price anomalies
in them. Perhaps this helps explain why CoT small specs' net-long
positions have remained flat for many years now.

Gold futures are a fascinating
and important realm, but they do not deserve the level of mysticism
and fear they seem to generate. The futures priesthood that "informs"
gold-stock traders often takes events out of context and disseminates
half truths designed to sway sentiment. While I find their babblings
rather amusing myself, it bothers me when my clients take them
as gospel and fear futures action when they have no need to.

Thus at Zeal, even though we
are primarily stock speculators, we track gold and silver futures
CoT data on a weekly basis. Our subscribers can log into our
website and look at big high-resolution updated versions of the
charts in this essay anytime they want. By seeing the entire
bull-to-date futures action at one time, it is much easier to
keep current developments in proper context and not be steered
astray by some paranoid guru.

In fact, during times like
these when futures gurus are seeing terrible portents of woe
in gold CoT data, we like to buy gold stocks. The gold-futures
being-used-to-manipulate-gold-stocks to-steal-from-the-little-guy
theories only thrive when sentiment is bad enough for a bottom
to likely be near. Thus we have been aggressively buying elite
high-potential gold stocks near technical lows in both our weekly and monthly newsletters.
Subscribe today
before gold stocks soar again and this opportunity vanishes!

The bottom line is the US CoT
data on gold futures is interesting, but it doesn't drive the
gold price. Global gold physical supply and demand does. The
CoT data merely offers a tiny nebulous view into classes of traders
that aren't very well defined and constantly shift. And it ignores
all the other non-COMEX gold trading worldwide. Therefore gold
futures CoT reports should be taken with a big grain of salt.

If some guru is wailing about
record commercial net shorts, then you can instantly know that
this also means record large-spec net longs. Maybe the glass
is half full. If someone is spewing fear because gold OI has
collapsed, realize it has already done this over a dozen times
yet gold has still nearly tripled. Gold futures CoT mysticism
is irrational and misplaced, don't be swayed by it.

Adam Hamilton, CPA

May 25, 2007

Thoughts, comments, or flames? Fire away at zelotes@zealllc.com. Due to my staggering and perpetually increasing e-mail load, I regret that I am not able to respond to comments personally. I will read all messages though and really appreciate your feedback!